Dissecting Crowdfunding

I wrote a piece on crowdfunding back in November, right after congress overwhelmingly passed The Entrepreneur Access to Capital Act.

Well, on April 5th, President Obama signed into law the Jumpstart Our Business Startups Act (aka the JOBS Act). This pretty much cements crowdfunding as an alternative to traditional capital raising channels.

That being said, the SEC will have 270 days to review the Act and set its own rules for investors and issuers looking to become involved in this new area of capital raising. Let's see how badly they mess up a good thing.

Although we've talked about it before, let's dive a bit deeper and tear the Act apart.

According to Oxford Dictionaries, crowdfunding is "the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet."

I like this definition from USLegal.com better: "Crowd funding refers to the collective cooperation, attention and trust by people who network and pool their money and other resources together, to support efforts initiated by other people or organizations. The purpose of crowd funding varies, from disaster relief to citizen journalism to artists seeking support from fans, to political campaigns. Crowd funding is also used for startup companies."

That last part is what we are interested in - startup companies. Title III of the Act covers crowdfunding of securities, like those a startup would issue to seed or fund its growth.

The Act creates a new exemption under Section 4 of the Securities Act of 1933 that permits the sale of securities (stock) through crowdfunding. Issuers (private companies) can now publicly sell up to $1 million of securities per year (every 12 months).

Despite some in the media's immediate negative reaction and assumption that crowdfunding will lead to widespread fraud, it's not a free-for-all - in fact, far from it. First of all, if you are already public, a foreign issuer, or a company considered an investment company under Section 3 of the Investment Company Act of 1940, sorry, but you will not be able to utilize crowdfunding.

As you'll see, the disclosure and registration requirements that intermediaries (brokers, or websites) and issuers have to adhere to are adequate enough to protect investors. Issuers still need to file with the SEC and provide information to the agency and investors. This information includes the issuer's business description and business plan; annual operational and financial reports; ownership and capital structure; and, a description of the intended use of the financing proceeds.

Issuers are not allowed to advertise (outside of the web-based portal or through a broker), and they cannot hire promoters, lead generators or finders. They must also provide the following financial information:

For offerings that have target amounts under $100,000, the issuer's most recent tax return and financial statements certified by its principal executive officers;

For offerings with target amounts between $100,000 and $500,000, the issuer's financial statements reviewed by an independent public accountant;

For offerings with target amounts of over $500,000, the issuer's audited financial statements.

Issuers need to set a target amount for the fund raising and a deadline to reach the target amount. The price of the offering, and how it was arrived at, needs to be disclosed, as does the ownership and capital structure of the issuer, including, among other things, a description of how the exercise of other shareholders' rights could negatively affect investors.

The intermediary broker or funding website also has to register with the SEC, and the funding transaction has to be conducted through one of those two channels. The broker or funding website also have to ensure that investors understand the risks of the investment and meet certain requirements, including:

If the investor's annual income or net worth is less than $100,000, the greater of $2,000 or 5% of the investor's annual income or net worth, or;

If the investor's annual income or net worth is $100,000 or more, 10% of the investor's annual income or net worth, but not more than $100,000.

The intermediary must also conduct background checks for each officer, director, and holder of more than 20% of the issuer's shares; disseminate the offering proceeds to the issuer only when the target offering amount is reached or exceeded; and ensure that no investor has exceeded the individual investment limit.

In most cases, the securities will also need to be held for 12 months before they can be sold. It's not as simple as some would have us believe, is it?

Once investors purchase a security via a crowdfunding financing, the purchased securities will be "Covered Securities." This pre-empts the application of state blue sky laws. States can still require a filing or payment of a fee with respect to securities issued under the crowdfunding exemption, but only if the issuer's principal place of business is in the state, or the purchasers of fifty percent or more of the aggregate amount of the securities sold are residents of the state.

States can also chase fraudsters and take enforcement actions if they feel something shady has occurred or an issuer has misrepresented the offering.

How do intermediary sites make money?

Good question. Given the clear restrictions in the Act regarding issuers' and intermediaries' ability to pay for promotion, or otherwise exchange fee for services, it will be interesting to see how the sites that evolve to fill this niche actually monetize their services!

Sites like IndieGoGo charge issuers a fee of between 4%-9%. Kickstarter charges 5% only if the funding is successful. However, the important difference is that these sites are not really funding companies, they are funding projects, and the people doing the funding are pledging very small amounts, and receiving something other than securities in exchange.

For instance... If I fund my buddies' rock band to go on tour in New York, I may receive tickets to their next local show, a t-shirt, or a copy of their latest CD single. Since these sites are not selling a "security," the same rules don't apply.

Under the Act, a crowdfunding website acts as an intermediary in a funding transaction, but does not offer investment advice or recommendations; solicit purchases, sales, or offers for the securities featured on the website; compensate its employees, agents or others for such solicitation or for the sale of securities featured on its website; or hold, manage or otherwise handle investor funds or securities.

So I'll ask it again, and if anyone out there knows the answer, please do tell... How will sites functioning as the middle men in crowdfunded securities transactions make money? And why would a traditional broker bother with any of this?

What about liability?

Issuers still have liability to investors under the Act. If they make an untrue statement of material fact, or fail to state a material fact in a transaction, an investor who purchases their security can bring an action against them.

Another thing worth mentioning is that since the Act's definition of "issuer" includes any person who offers or sells a security in a crowdfunding transaction and, to the extent that they offer or sell a security in such a transaction, also includes the issuing company's directors, partners, and principal executive, financial and accounting officers, there exists a great deal of personal liability for officers and directors.

One of the most interesting sections of the Act regards "aggregate capital raised," and the all-or-none nature of crowdfunding transactions. An intermediary may provide offering proceeds to the issuer only when the aggregate capital raised is equal to or greater than the target offering amount, and the issuer must allow all investors to cancel their commitments to invest. This implicates Rule 10b-9 of the Securities Exchange Act, which requires that, in an all-or-none offering, any money paid for the securities be "promptly refunded" to investors if all of the securities are not sold.

So after all that, come up $1,000 short and forget it?

What do we make of all this?

We were chatting with our friend Dan Faiman, who is working on a platform in this space as well. Faiman feels that we'll see hundreds of sites pop up to try and take advantage of the perceived opportunity in this space. He has a few ideas of his own about how to monetize a site like this without running afoul of the Act or its likely interpretations.

As mentioned earlier, the SEC has yet to formulate any rules on crowdfunding, but you can be sure that they will have quite a lot to say. What this whole thing looks like once they get through with it is anyone's guess. Those that are rushing headlong into the space willy-nilly are likely to find themselves heading upstream, sans paddles.

It seems that a prudent approach would be to sit back and wait until we get a bit more clarity. Meanwhile working to create something where you're not just providing a match-making service between investor and project, but actually adding a bit of value in between, may just be the way to go.